Ifo Institute – Leibniz Institute for Economic Research at the University of Munich Estimating Economies of Scale and Scope with Flexible Technology Thomas P. Triebs David S. Saal Pablo Arocena Subal C. Kumbhakar Ifo Working Paper No. 142 October 2012 An electronic version of the paper may be downloaded from the Ifo website www.cesifo-group.de. Ifo Working Paper No. 142 Estimating Economies of Scale and Scope with Flexible Technology Abstract Economies of scale and scope are typically modelled and estimated using cost functions that are common to all firms in an industry irrespective of whether they specialize in a single output or produce multiple outputs. We suggest an alternative flexible technology model that does not make this assumption and show how it can be estimated using standard parametric functions including the translog. The assumption of common technology is a special case of our model and is testable econometrically. Our application is for publicly owned US electric utilities. In our sample, we find evidence of economies of scale and vertical economies of scope. But the results do not support a common technology for integrated and specialized firms. In particular, our empirical results suggest that restricting the technology might result in biased estimates of economies of scale and scope. JEL Code: D24, L25, L94, C51. Keywords: Economies of scale and scope, flexible technology, electric utilities, vertical integration, translog cost function. Thomas P. Triebs David S. Saal Ifo Institute – Leibniz Institute for Aston University Economic Research Aston Triangle at the University of Munich B$ 7ET Poschingerstr. 5 Birminghamton, UK 81679 Munich, Germany Phone: +44(0)121/204-3220 Phone: +49(0)89/9224-1258 [email protected] [email protected] Pablo Arocena Subal C. Kumbhakar Public University of Navarre State University of New York Business Administration Department at Binghamton Campus of Arrosadia Department of Economics 31006 Pamplona, Spain PO Box 6000 Phone: +34(0)948/169-000 Binghamton, New York 13902-6000, USA [email protected] Phone: +1(0)607/777-2572 [email protected] 1. Introduction Economies of scale and scope are fundamental concepts explaining many economic decisions. From a business perspective, they play a central role in assessing the potential benefits of firms’ growth and diversification strategies. From an industry perspective, they are central for the determination of efficient market structures. In particular, they are the basis for the restructuring and deregulation of network industries worldwide. For instance, changes in the economies of scale of electricity generation swayed many countries to liberalize electricity markets. Subsequently the belief that gains from competition would outstrip any losses in economies of scope led many countries to mandate electric utilities to divest their generation assets to prevent discrimination in newly developed wholesale markets. Similarly many banks today argue that economies of scale and scope make large integrated banks more efficient and caution against their break-up to minimize the risk from individual bank failures. Duality theory1 allows us to estimate the underlying production technology via a cost function. Thus almost the entire literature on the estimation of economies of scale and scope follows the seminal work of Baumol et al. (1982) and employs a cost function based approach, which allows identification of the “the production technology of the firms in an industry”. That is, it is (implicitly) assumed that all the firms in an industry share the same production technology. Hence, empirical studies have traditionally focused on the estimation of an industry cost function, common to all firms in the industry. However, this approach ignores the theoretical, but empirically testable possibility that different types of firms employ different production technologies. Moreover, maintaining the assumption of a common technology when heterogeneous technologies are present could potentially lead to biased estimates of costs and therefore, biased estimates of economies of scale and scope. Our approach therefore departs from the existing modelling approach for measuring scale and scope economies by allowing for differences in technologies across firms types. This is accomplished by specifying a model where technology can be fully flexible across specialized and non-specialized firms. We therefore allow for firm-type specific technologies which are estimated jointly without separating the sample. We demonstrate that this approach can be applied to any functional form including the popular translog form introduced by Christensen et al. (1973). This is important because, despite the widely accepted advantages of the translog specification, the non-admission of zero values in the translog form has 1 Duality theory and the implied restrictions on the cost function ensure that the latter does not violate the physics of production. For an introduction see the survey by Fuss und McFadden (1978). 2 previously been seen as precluding its use for the estimation of economies of scope (Caves et al. 1980). Our model is conceptually different from models that try to estimate production functions involving zero output quantities (Battese, 1997), and it is more general than other attempts to estimate separate technologies (e.g., Weninger 2003, Bottasso et al. 2011) because it does not require a Box-Cox transformation which is difficult to estimate. That is, our model is easier to implement for the applied researcher as it is linear in parameters and all coefficients have direct economic interpretations (at the mean of the data). We finally note that our model readily allows for statistical testing of whether a common or flexible firm type technology specification is appropriate, We empirically demonstrate the usefulness of our modelling approach by estimating economies of scale and scope with a sample of publicly-owned US electric companies. Although our modelling approach is applicable with any functional form, our empirical specification demonstrates that, contrary to popular belief, a translog specification can be used to represent the technology for both specialized and non-specialized firms. Our data is suitable for this task as it comprises both specialized (generating-only and distributing-only) and integrated firms. Our results indicate that within our sample, cost relationships differ between integrated and specialized firms, suggesting that the assumption of a restricted technology may indeed lead to biased estimates of economies of scale and scope in our sample. The rest of the paper is organized as follows. Section 2 provides the necessary theoretical background including the relevant literature. Section 3 sets out our contribution to the modelling of economies of scale and scope. Section 4 introduces our empirical model and tests. Section 5 introduces our application. Section 6 presents the results and section 7 gives a short conclusion. 2. Scale and Scope Economies with a Common Technology There are a vast number of studies that estimate economies of scale and scope for various multiproduct industries. We do not review this literature here. Instead we provide a short summary of the debate on how to model and estimate multiproduct or multistage cost functions. We first recall the definition of scale and scope economies. Let N = {1,2,…,N} be the set of products under consideration, with output quantities y = (y1,…,yn). The function C(y,w) denotes the minimum cost of producing the entire set of products, at the output 3 quantities and input prices indicated by the vectors y and w. The degree of scale economies defined over the entire product set N, at y, is given by , 1 1 , ∑ , ∑ ln/ln where Ci is the first derivative of cost with respect to product i. Returns to scale are said to be increasing, decreasing or constant as S is greater than, less than, or equal to unity, respectively. Let us now consider two subsets, SU N, and SD N such that SU SD = N, and SU ∩ SD = Ø. Let yU denote the vector whose elements are set equal to those of y for i SU and yD denote the vector whose elements are set equal to those of y for i SD. Similarly, C(yU,w) and C(yD,w) denote the cost of producing only the products in the subset U and D, respectively. The degree of economies of scope between yU and yD is defined as , , , 2 , , , The degree of economies of scope SC is measured by (2) where the separation of production is said to increase, decrease or leave unchanged the total cost as SC is greater than, less than, or equal to zero, respectively. Equation (2) shows that the estimation of economies of scope (i.e. the costs and benefits of joint production) requires the comparison of costs between specialized and non-specialized firms at a given vector of input prices. In our below application, this measure of economies of scope can be readily interpreted as a measure of firm’s vertical integration economies in a multi-stage context. Thus, if N denotes the entire product set along the firm’s vertical chain, SU denotes the subset of upstream only products, and SD=N-SU denotes the subset of downstream only products, then (2) measures the degree of vertical integration economies. For empirical estimation of (1) and (2) the researcher has to choose an appropriate functional form, obtain relevant data, and decide on a model of the underlying production technology. We now discuss each point in turn. For multiproduct cost functions, Caves et al. (1980) set out three criteria for the ex-ante choice of functional forms: satisfaction of regularity conditions, limited number of parameters, and the ability to admit zero values for some outputs. In the general empirical literature the translog and the quadratic are the most popular functional forms. However, the translog form, despite its wide application, has an 4 important drawback in that the cost function is undefined for a zero output level. This is important because the measurement of economies of scope requires the comparison of costs between specialized and integrated firms; and specialization requires that the production of at least one of the outputs is zero.